Picking pennies in front of a steamroller

Contents

Firms Involved

American International Group (AIG)

Year of the event

2008

Description of the case

AIG is one of the largest American insurance company. Under the leadership of Martin J. Sullivan, who became CEO in 2005, AIG increased massively its exposure to mortgages. Considering this activity as relatively safe, the insurer did not use reinsurance to diversify away from the risk. When the subprime crisis erupted, massive defaults on mortgages occurred, leading AIG to lose $99.2bn. In particular, the Credit Default Swaps (CDS) alone, through which AIG was selling insurance, generated a loss of $30bn. Securities lending accounted for $21bn of loss, as the insurer used the cash collaterals provided by this activity to invest in high-yield mortgage-backed securities[1]. AIG being deemed too big to fail, the government bailed AIG out, in particular through a series of loans, which were eventually paid out.

Take-aways

Too big to fail institutions are bailed out. Even when the Government clearly states the opposite.

Insurers tend to collect small premiums to bear huge fat tail risks. This is a fragile business exposed to Black Swans.